Greek death spiral hits bank credit ratings. What should the EU do?

The interesting thing about credit ratings is how a poor rating is predicated on poor fundamentals while poor ratings in turn have a nasty effect on those fundamentals. It’s almost like a company – or country, for that matter – reaches a tipping point where the chicken and egg cause and effect take it into a death spiral from which there is no escape. That’s certainly what we saw with Enron. Even without the fraud, its goose was cooked as its financial health was predicated on maintaining specific credit ratings – which it failed to do. Is this what we are witnessing in Greece too?

Greece’s four largest lenders, including National Bank of Greece SA and EFG Eurobank Ergasias SA, had their credit ratings lowered at Fitch Ratings, which said the country’s economic crisis will hurt asset quality.

Fitch cut the long-term issuer default ratings of Alpha Bank SA, EFG Eurobank, National Bank of Greece and Piraeus Bank SA one step to BBB, the second-lowest investment grade rating, from BBB+, with a negative outlook, it said in a statement today. The short-term default rating was cut one level to F3, the lowest investment-grade rating, from F2…

Concern that Greece will struggle to finance its deficit has roiled financial markets since the country revealed it had a budget shortfall of 12.7 percent last year. Greece is targeting cutting the deficit to 8.7 percent this year. That is likely to affect the Greek banks’ asset quality, which may lead to higher credit costs and lower underlying profitability, Fitch said.

“The rating actions reflect Fitch’s view that the banks’ already weakening asset quality and profitability will come under further pressure due to anticipated considerable fiscal adjustments in Greece,” it said. “Fitch believes the required fiscal tightening that needs to be made by the Greek government will have a significant effect on the real economy, affecting loan demand and putting additional pressure on asset quality.”

Wait a minute – I thought flagging demand had a significant impact on the real economy. So you see, the Greek government’s anticipated budget cuts, ‘fiscal austerity’ will affect the real economy, which in turn decreases demand for credit and weakens the banking sector. The lower demand for credit, in turn, further weakens the real economy. Anticipating all of this, the ratings agencies pile on, downgrading the banks, increasing their cost of capital. And on it goes. Let’s not forget the capital flight we are now seeing either. That has to weaken Greek banks.

Here’s my question: when does this affect the Greek sovereign credit rating? That has to be next because the scenario I just scoped out would indeed suggest lower tax revenue and more budgetary pressure.

Sure sounds like a death spiral to me.

When Greece was downgraded by Fitch to BBB+ in December, I quoted Fitch, writing:

Greece has been downgraded by Fitch Ratings to BBB+ over concerns about its budget deficit. Despite the cut, Fitch maintained a negative outlook on the country’s ratings, meaning it could fall further in the near future. This action highlights how the real sovereign debt crisis is in Europe not in Dubai.

The ratings agency said:

The downgrade reflects concerns over the medium-term outlook for public finances given the weak credibility of fiscal institutions and the policy framework in Greece, exacerbated by uncertainty over the prospects for a balanced and sustained economic recovery.

It does seem that another sovereign downgrade is the next headache to worry about. Are the ratings agencies exercising ‘restraint’,’ cognizant that their decisions have severe political and economic implications at this juncture? Please comment if you have any insight.

My view is this: when the credit crisis hit in September 2008, the European Central Bank (ECB) loosened its rules governing the ratings of the collateral banks could use for loans from the central bank. From that time forward, banks were permitted to use government bonds rated BBB or above as collateral in ECB money market operations. The ECB has signalled that this would come to an end soon. So, regardless of credit downgrade, this makes Greek banks even more vulnerable as they are the ones most likely to use Greek government debt as collateral for loans. I previously commented on this when addressing foreign exposure to Greek debt.

Are the politicians even thinking about this? Talk about Minsky moments. We are facing one right now.

It reminds me a little of the subprime crisis. When it engulfed Bear Stearns, policy makers stepped in with bailout money. The immediate problem of Bear Stearns’ collapse was solved, but the systemic issues remained. Yet, recklessly, policy makers did almost nothing in the few months afterwards to deal with those issues. This was a crucial error given that people like me were warning of impending calamity. I was mystified (see comments at the end of my Swedish crisis post). The Minsky moment came and policy makers missed it entirely.

In fact, many were incensed because they thought Bear should have failed. So when Lehman came around, it did fail. And we all know how that turned out.

So, here we are again. The sovereign debt crisis has been building for three months now – ever since Dubai World announced it wanted to default on its loans. In my view, we have now reached a critical juncture. If Greece is allowed to default, all hell will break lose. On the other hand, Greece has run a deficit for years. It’s ‘cheated’ to meet the standards set forth in its previously agreed-to treaties and it is unwilling to take austerity measures that Ireland, faced with similar circumstances, has taken. What should the EU do?

The dilemma is this: how do you eliminate moral hazard for perceived free riders while still credibly safeguarding against the destruction and contagion that a Eurozone sovereign default would create?

I say the EU should enforce an austerity plan (moral hazard prevention) via the IMF (credibility) in exchange for both a one-time fiscal transfer (economic destruction safeguard) and access to an IMF emergency aid fund (contagion safeguard). I believe the Eurozone’s current structure is unworkable and that the Stability and Growth Pact is too restrictive. But, right now, the issues are the ones I outlined.

If the Eurozone can get through the crisis in Greece, it can use the same tactics elsewhere and credibly commit to preventing a sovereign default of any country that submits to the plan.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

I still contend that the most effective solution to the present EU sovereign debt crisis would be to issue jointly EU bonds to refinance gradually all the maturing debt of the PIGS. This would not only significantly reduce the cost of financing of PIGS debt, while creating a EU bond market, but it would replace any International Monetary Fund role and/or conditional loans.

Zac says 9 years ago

It is ideal solution, but still you have moral hazard problem – more reckless behaviour, esp. by politicians as Ed said.

Rating agencies are very questionable – its like self fulfilling prophecy, so now in debt driven recession they become recession multipliers. They are like people who stands by house who is on fire, and they say well this house could burn to the ground, and then they toss some oil to the house.

Paulkeegan59 says 9 years ago

Greek debt problem has been largely caused by specualtors
with a mere US25k we moved the implied CDS by a full 1000 (onethousand) basis points on one of the major Greek banks – a complete joke ! of course at 20% interest EVERYBODY is bust ! the CDS scams must be stopped